China's currency becomes election issue

The value of China's currency has become an election issue. But could U.S. action spark a backlash from China?

Monetary policy is a hot topic this election season. But forget the Federal Reserve -- it's China's currency that is drawing the attention of Mitt Romney.

The Republican presidential candidate has pledged to label China a currency manipulator on his first day in office. And if China does not move quickly to float its currency, the yuan, Romney would slap duties on Chinese imports.

"One of the ways they don't play by the rules is artificially holding down the value of their currency," Romney said last week. "China has been a currency manipulator for years and years and years."

China is on the agenda for Monday's final presidential debate. Odds are, Romney will again repeat his pledge and slam the Obama administration for its decision to delay a report on exchange rates that could have been used to denounce China's currency manipulation.

President Obama can, in turn, point to a 10% increase in the value of the yuan since 2010 and claim administration pressure on Beijing is already working.

So what's all the fuss about?

China has long been accused of keeping the yuan artificially low by hoarding foreign reserves. That, in turn, gives Chinese exporters an advantage over competitors.

It works like this: In an effort to control the exchange rate, China sells its own currency, while making large purchases of foreign currencies, often the U.S. dollar.

The manipulation distorts capital flows, and has the potential to impact labor markets and trade. Currency market intervention of this type is a violation of International Monetary Fund rules -- but they are seldom enforced.

Manipulation creates advantages for China. By keeping the yuan's value low compared to the dollar, China's goods are much more attractive to American consumers. At the same time, products manufactured in the U.S. are more expensive for buyers in China.

China's currency was formerly "pegged" to the U.S. dollar, which is to say they moved in tandem. But Beijing agreed to loosen that link in 2010, and allow the yuan more flexibility to appreciate. Since the announcement, the yuan has appreciated by almost 10%.

But many analysts argue the currency should be much stronger. Estimates vary widely, but some economists think the yuan remains undervalued by 10%, 20% or even more.

China is far from the only state manipulator. Switzerland and Japan, for example, recently intervened in currency markets. Both currencies had been bid up in speculative "safe haven" trades last year due to the deteriorating outlook for the dollar and euro.

While the United States has promised not to deliberately weaken the dollar, some critics say that by printing money and flooding the U.S. economy, the Fed's quantitative easing plan is essentially doing just that.

It's not clear whether Romney would follow through on his plan to designate China a currency manipulator. Talking tough on China has become a campaign ritual for politicians of both parties -- even if, as experts predict, the rhetoric moderates after Nov. 6 regardless of who wins.

Labeling China a currency manipulator is largely a symbolic gesture. The move could trigger talks with China, but no immediate, punitive actions are attached to the designation.

Economists are more worried about the second part of Romney's plan, which is to direct the Department of Commerce to institute countervailing duties if China "does not quickly move to float its currency".

That could spark a trade war, which would be damaging for the world's top two economies.